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Beyond the Business Cycle: The Need for a Technology-Based Growth Strategy potx






Beyond the Business Cycle:
The Need for a Technology-Based Growth Strategy


Gregory Tassey*
Economic Analysis Office
National Institute of Standards and Technology
tassey@nist.gov

February 2012



Although this paper is primarily an assessment of alternative economic growth strategies,
implications for specific policy instruments are unavoidable. Any such statements are mine
alone and do not represent official positions of NIST or the Department of Commerce.


*I am indebted to Stephen Campbell, Albert Jones and Phillip Singerman for helpful comments
on previous drafts.







Abstract

Facing the worst economic slowdown since the Great Depression, efforts to reestablish
acceptable growth rates in both Europe and the United North America are relying to a great
degree on short-term “stabilization” policies.
In a structurally sound economy, the neoclassical growth model states that appropriate
monetary and fiscal policies will enable price signals to stimulate investment. The subsequent
multiplier effect will then drive sustainable positive rates of growth. However, these
macrostabilization policies can do relatively little to overcome accumulated underinvestment in
economic assets that create the needed larger multipliers. This underinvestment has led to
declining U.S. competitiveness in global markets and subsequent slower rates of growth—a
pattern that was underway well before the “Great Recession.”
However, the massive monetary and fiscal “stimulus” applied since 2008 in the United States
has had only a modest impact on economic growth. The reason is that the prolonged current
slowdown is a manifestation of structural problems. Thirty-five years of U.S. trade deficits for
manufactured products cannot be explained by business cycles, currency shifts, and trade
barriers, or by alleged suboptimal use of monetary and short-term fiscal policies.
High rates of productivity growth are the policy solution, which can be accomplished only
over time from sustained investment in intellectual, physical, human, organizational, and
technical infrastructure capital. Implementing this imperative requires a public-private asset
growth model emphasizing investment in technology.
This paper assesses the limitations of monetary and fiscal policies for establishing long-term
growth trajectories and then describes the basis for a technology-based economic growth
strategy targeted at long-term productivity growth. This growth model expands the original
Schumpeterian concept of technology as the long-term driver of economic growth where
technology is characterized as a homogeneous entity that is developed and commercialized by
large-firm dominated industry structures. Instead, the new model characterizes technology as a
multi-element asset that evolves over the entire technology life cycle, is developed by a public-
private investment strategy, and is commercialized by complex industry structure that includes
complementary roles by large and small firms.








Beyond Stimulus and Debt Reduction:
The Need for a Technology-Based Growth Strategy

Gregory Tassey


Like Albert Einstein who spent the last half of his life trying to develop a unified field theory,
the U.S. economy is locked in a seemingly perpetual search for a unified macro-micro economic
growth model. The importance of this search has been accentuated by the persistent weak
performance of the U.S. economy following the 2008-09 recession, which has created growing
concerns regarding the ability to return to acceptable long-term rates of growth. These
concerns have been expressed largely in the form of a debate over the right combination of
monetary and fiscal policies.
However, “macrostabilization” (monetary and fiscal) policies have strong limitations with
respect to stimulating long-term economic growth. This fact creates the need for a shift to
greater emphasis on microeconomic growth policy—an imperative that has reached crisis
proportions due to a decades-long underinvestment in productivity-enhancing assets,
especially technology. At least Einstein realized that “we can't solve problems by using the
same kind of thinking we used when we created them.”
Introduction
The level of consternation over sluggish growth has been particularly high in the United States
because in the decades following World-War-II, the United States benefited from a structurally
superior economy, characterized by the accumulation of a set of economic assets that drove
high rates of productivity growth. This fact enabled macrostabilization policies to be used
successfully to maintain an environment sufficient to attain acceptable growth rates. Such
policies (various forms of neoclassical and Keynesian economics) rely on stimulating some
combination of investment and consumption until the economy attains “escape velocity”—that
2

is, re-establishes acceptable and sustainable private-sector rates of economic growth.
1

One explanation for the weak response to monetary and fiscal policies is the balance-sheet
deterioration of both consumers and all levels of government during the preceding decade.
However, this high-debt problem is manifestation of the underlying trends that are restraining
the potential for long-term recovery. In fact, this paper argues that the root problem is years of
accumulated underinvestment, reflected in numerous economic indicators, such as decades of
U.S. trade deficits. The explosion of debt has been an unfortunate choice of a response to an
increasingly rapid globalization of the world’s economy, the result of which has been a rapid
growth in the productivities of other nations relative to the United States. Therefore, a new
growth paradigm is needed based on a greater reliance on investment across a wide range of
assets. The “range of assets” is a critical dimension of the proposed growth paradigm, as this
portfolio distinguishes “neo-Schumpeterian” from traditional neoclassical growth philosophies.
The core of a “national economic strategy” is a sustained, high rate of productivity growth.
Yet, this central role of productivity is still questioned by some, who argue that the increase in
output per unit of labor reduces employment. However, even though productivity growth
typically reduces the labor content of a unit of output, the resulting combination of improved
product and price performance yields larger market shares. This, in turn, creates a demand not
only for additional workers but also for higher skilled and thus higher paid ones in order to
produce the more technically sophisticated products demanded by today’s consumers. The cost
of inadequate productivity growth is seen clearly in a number of economies in the form of
falling relative incomes.
2

Advances in technology are the only source of permanent increases in productivity (Basu,
Fernald, and Shapiro, 2001). In contrast, economic studies have shown that technologically
stagnant sectors experience slow productivity growth and, therefore, above average cost and
price increases. Rising prices increase these sectors’ measured share of nominal GDP, thereby
lowering national productivity growth (Baumol, 1967; Nordhaus, 2006).
In essence, the long-term growth paradigm is driven by a set of fiscal policies, but these
policies must be investment oriented and transcend many business cycles. In contrast to
stabilization policies, the emphasis must be on investment in a range of productivity-enhancing
technologies, as opposed to the traditional (and current) reliance on an investment component
that focuses largely on conventional economic infrastructure such as transportation networks.
While such “shovel-ready” investment projects are having a positive impact and are essential
for an economy with a deteriorated traditional economic infrastructure, the scope and


1
Atkinson and Audretsch (2008) provide an excellent comparative assessment of the alternative dominant major
economic growth policy philosophies in terms of their respective approaches to achieving allocative and
productive efficiency. In addition, they describe a third growth philosophy, innovation economics, which adds
adaptive efficiency as a third policy target. Audretsch and Link (2012) elaborate on the weaknesses of
neoclassical economic growth theory and add an assessment of Schumpeter’s innovation theory.
2
A NBER study found that the average productivity advantage of the United States over OECD countries as a
group accounted for three quarters of the per capita income difference (McGuckin and van Ark, 2002).

3

magnitude is inadequate for a long-term growth strategy.
Equally important, such a strategy must be based on a growth model that reflects the
increasingly complex and technology-intensive nature of global competition. The development
and utilization of technologies on a scale large enough to attain significant global market shares
for domestic industries require investment in a number of other categories of assets. They
include human capital, better channels for technical and business knowledge diffusion to firms
of all sizes, incentives for capital formation, intellectual property protection, and modern
industry structure (i.e., co-located and functionally integrated supply chains). These assets form
the foundation of a broad ecosystem that functionally integrates R&D, capital-formation,
business management, and skilled labor. The emerging innovation ecosystem is a far more
complex and integrated complex of industries, universities, and government institutions than
what characterized the industrial revolution. This model is emerging on a global basis and thus
a domestic economy-wide response is imperative.
Demand-Stimulation Policies Are Not Working
From 2001-2010, American households increased their debt by $5.7 trillion (75 percent), state
and local governments increased their debt by more than $1 trillion (89 percent), and, the
Federal Government increased its debt by $6 trillion (178 percent).
3
This expansion of domestic
demand should have ratcheted up the economy’s growth rate. Instead, average annual real
GDP growth was less than half (45 percent) of the average for the previous four decades.
4

This apparent contradiction to conventional growth theory has been largely unnoticed.
Instead, traditional Keynesian economists and policy analysts argue for more of the same
monetary and short-term fiscal stimulus. The only “structural” problem regularly mentioned is
the excessive debt of the U.S. economy; hence, the label “balance-sheet” recession. It is true
that the huge debt burden is restraining consumption and hence recovery, but this debt has
only been a device to maintain consumption in the absence of real growth driven by adequate
investment.
Monetary Policies. The conventional Federal Reserve Board response to recessions is to lower
short-term rates. Historically, low interest rates induce consumers to spend and, by steepening
the yield curve, stimulate banks to lend. This, in turn, promotes businesses to invest. The
resulting capital formation drives future growth. This is the basic neoclassical growth model.
To attain a steeper yield curve, the Fed lowered interest rates aggressively. This strategy has
reached its limit since 2008 with rates approaching zero or even negative values in real terms.
Yet, consumers increased consumption modestly at best and companies have held back on
investment and hiring. Instead of responding to the steepened yield curve with increased
lending, banks have bought U.S. Treasury bonds, in effect borrowing from the government and
then lending back to it at a higher rate.


3
Federal Reserve Board, Flow of Funds Accounts, Table L.1 (historical tables).
4
From BEA NIPA Table 1.2.1 (real average annual GDP growth rates were 3.5 percent for 1961-2000 and 1.6
percent for 2001-2010).
4

Sustained low interest rates cause individuals and companies to be indifferent between
holding cash and short-term investments such as Treasury notes. This “liquidity trap”, as it is
called in economic text books, slows the velocity of money and hence economic activity. In such
a situation, monetary policy in the form of lower rates becomes ineffective. Moreover, in a
balance-sheet recession, households are focused on reducing debt, not incurring it, which
makes them insensitive to low interest rates with respect to propensity to borrow.
5

In recent decades, economists have rejected at least the seriousness of the liquidity-trap
effect, if not the concept itself. This view arises partially from the fact that when lowering short-
term rates through conventional open market operations fails, the Fed can fight the liquidity
trap with “quantitative easing,” in which the Fed purchases longer-term financial assets from
banks and other private institutions with new electronically created money. The desired result
is to expand the money supply and not only lower long-term interest rates but also inflate
assets (particularly the stock market), thereby creating a positive wealth effect that ostensibly
leads to increased consumption. In this case, the Fed initiated two rounds of quantitative
easing, known as QE1 and QE2, which together pumped about $2 trillion into financial markets.
However, the longer the current economic slowdown persists in the face of this massive
monetary stimulus, the weaker this strategy becomes. Quantitative easing aimed at lowering
long-term rates is increasingly unproductive as these rates approach the risk premium for each
maturity, in effect creating risk-adjusted rates of zero.
6
A second negative aspect of lowering
long-term rates is that doing so flattens the yield curve, thereby reducing the incentive for
already reluctant banks to lend. Yet, after QE1 and QE2 did not produce the desired results, the
Fed did just that by initiating “Operation Twist” in another attempt to revive the moribund
housing market. This policy instrument is not designed to add liquidity. Instead, it consists of
selling short-term Treasuries and buying an equal amount of long-term Treasuries in order to
lower long-term rates (and, in the process, flattening the yield curve).
At this point, the only option for monetary policy is more quantitative easing for the purpose
of stimulating inflation. The objective would be to maintain negative real interest rates and
thereby finally induce more borrowing. With American households now in a long-term process
of restructuring balance sheets, such policy initiatives are likely to continue to be ineffective.
A final but little discussed negative impact of prolonged interest rate suppression is a
substantial reduction in interest income for retirees and investors who depend on this income,
which in turn reduces consumer demand. Of course, a reduction in consumer income must be
traded off against the negative effects of higher rates on borrowing by both consumers and
businesses. Still, it is counterproductive to stimulate demand in one sector while suppressing it


5
As pointed out in a Council on Foreign Relations report, “In every previous postwar recovery, the stock of
household debt has risen as the recovery has begun. In the current recovery, the collapse in home prices has
severely damaged household balance sheets. As a result, consumers have avoided taking on new debt. The
result is weak consumer demand and, hence, a slow recovery.” See Bouhan and Swartz (2011).
6
The risk premium is the amount of a rate above zero that accounts for interest rate variability; thus, a 2 percent
10-year Treasury is the equivalent of a zero interest rate, assuming 2 percent is the risk premium.
5

in another, especially when the stimulus instrument is experiencing declining effectiveness.
7

Fiscal Policies. After the large debt accumulation in the 2000s, fiscal stimulus became even
more aggressive in the 2008 recession three following years with annual budget deficits for
2009-2011 well over $1 trillion. Of particular relevance for long-term growth strategies is the
fact that this fiscal stimulus has included an investment component. However, as discussed in
subsequent sections, the amount and composition of this component is too small, too short-
term, and inadequate from a long-term economic growth portfolio perspective.
Many analysts have been frustrated by the fact that in spite of healthy balance sheets and
large cash reserves, U.S based businesses have not aggressively invested domestically, while
increasing investment in in other economies. For example, NSF survey data that show U.S.
manufacturing firms’ investment in R&D outside the United States has been growing at almost
three times the rate of these companies’ domestically funded R&D.
8

U.S. companies have done so (1) as a response to increased global market opportunities and
competition and (2) because the host countries are offering greater incentives not only for R&D
but subsequent commercialization. The bottom line is that the U.S. government has provided
neither similar incentives nor a multi-faceted long-term investment strategy to increase the
rate of return on private-sector investment in the domestic economy.
The resulting consequences of inadequate long-term domestic investment incentives are
evident in a wide range of indicators:
Private nonfarm employment decreased 3.3 percent in the decade 2000-2010.
9

Average annual real GDP growth during this period was 1.6 percent.
10

Real median household income declined in this decade by 7.0 percent.
11

Over the past 30 years (1980-2010), government transfer payments have risen from
11.7 percent to 18.4 percent of personal income.
12

In the first half of 2011, new single-family home sales fell to the lowest level since 1963,


7
A study by Ford and Vlasenko (2011) estimates that one year after the end of the recession in June 2009, the
volume of interest-sensitive assets held by U.S. households ranged from $9.9 to $18.8 trillion. At that time (June
2010), the average interest rate on Treasuries was 2.14 percent, compared to an average of 7.07 percent at the
same point in the previous nine recoveries. The projected annual impact of the lost interest income on the
conservative estimate of $9.9 trillion in interest-sensitive household assets is $256 billion in reduced consumer
spending, a 1.75 percentage point reduction in GDP, and the loss of 2.4 million jobs.
8
Sources: National Science Foundation’s Science and Engineering Indicators 2006 and 2008 and Research &
Development in Industry 2007. Between 1999 and 2007, foreign R&D funded by U.S. manufacturing firms grew
191 percent and their funded R&D performed domestically grew 67 percent.
9
Bureau of Labor Statistics, Current Employment Statistics, Series CES0500000001. Nonfarm employment
(includes government) declined 1.5 percent.
10
Bureau of Economic Analysis, National GDP Trends.
11
Census Bureau, Historical Income Tables H-6.
12
New America Foundation (based on Bureau of Economic Analysis data).
6

when records were first kept and when the population was 120 million less.
13

Nearly half of American households are viewed as “financially fragile.”
14

In 2011, approximately 13 percent of the population received food stamps.
15

The Federal Government’s own estimates indicate that at least five years will be required to
return to “normal” employment rates.
16
Yet, many Keynesian economists continue to claim that
the reason for the sluggish response of the American economy was that the recent government
fiscal stimulus was too little and incorrectly structured. In particular, they argue that it
contained too great a reliance on tax cuts.
17

In response, Paul Krugman (2009) and other macroeconomists have called for even larger and
better directed government fiscal stimulus based on two premises. First, they argue that
persistent slack in the economy’s capacity utilization means that government deficit spending
can continue without inflation as long as this slack remains.
18
Second, they continue to espouse
the Keynesian view that such fiscal stimulation will eventually cause the multiplier effect to kick
in to a degree sufficient to achieve an acceptable and self-sustaining rate of growth.
The core of U.S. fiscal policy aimed at achieving recovery from the Great Recession was the
American Recovery and Reinvestment Act of 2009, funded at $787 billion. While ARRA was
certainly a major stimulus program, only a modest share of the total funding was directed at
investment. Specifically, $105.3 billion was allocated to traditional economic infrastructure
projects (highways, bridges, public transportation, etc.). An additional $48.7 billion was directed
at energy infrastructure and energy efficiency (including a small amount for energy research
and manufacturing scale-up). Only $7.6 billion was allocated to support “scientific research.”
Compositional issues aside, ARRA was an aggressive short-term fiscal stimulus strategy.
However, it is over longer periods of time that investment strategies determine economic
growth rates. To this end, an increase in national investment requires a similar increase in


13
http://www.census.gov/const/soldann.pdf.
14
Lusardi, A., D. Schneider, and P. Tufano (2009).
15
U.S. Dept. of Agriculture, http://www.fns.usda.gov/pd/29SNAPcurrPP.htm. Approximately an additional 4-5
percent had incomes sufficiently low to qualify for food stamps, but for various reasons they did not apply for
them.
16
The Federal Reserve Board in November 2010, after over two years of aggressive U.S. fiscal and monetary policy
and in the midst of second round of monetary base expansion (“QE2”), lowered its estimates of economic
growth. The Fed minutes from the November meeting stated that “the economy would converge fully to its
longer-run rates of output growth, unemployment, and inflation within about five or six years.” One year later in
a November 2, 2011 press conference following an FOMC meeting, Chairman Bernanke stated that the pace of
economic recovery would remain “frustratingly slow.”
17
It is true that tax incentives are a weaker demand-stimulation policy tool in an economy where (1) household
balance sheets are heavily burdened by debt and (2) the employment outlook is weak for an extended period. In
such an economy, significant portions of general tax cuts are used to pay down debt or increase savings. Hence,
the benefits to demand stimulation will be relatively weak.
18
In January 2011, U.S. industry was operating at 72.3 percent of capacity compared to a long-term average (1972-
2010) of 80.5 percent (http://www.federalreserve.gov/releases/g17/current/default.htm).
7

savings. The critical requirement is that these savings be directed into investments that yield
productive assets, as this strategy is the only way to grow real incomes in the long run.
Productivity is a growing imperative, as the world’s economy is becoming increasingly
technology based with the result that productivity growth rates in many countries are
accelerating. The policy message is that only the most efficient existing or newly created
economic assets will be viable in the future. To survive, companies, industries and entire
economies will have to become more productive by rapidly assimilating existing technologies
and developing new ones.
Unfortunately, the structural problems increasingly evident within the U.S. economy have
taken a long time to accumulate and similarly will require a long time to resolve. Specifically,
the needed paradigm shift will not happen automatically for several reasons. First, the
“installed wisdom” that led to inadequate growth policies remains entrenched even in the face
of accumulating evidence that change is imperative. Strategies that worked in the past are
presumed to be just as viable in the future. Moreover, the trauma associated with learning new
investment and management strategies becomes a second significant barrier to adaptation
(acquiring new “economic wisdom”).
Second, an “installed-base” effect exists, which is the result of decades of accumulated
economic assets. The owners of these assets face considerable risk in writing them off and
shifting to a new asset mix with the consequent short-term increase in expenditures and
uncertain productivity gains, even though current economic conditions dictate it should be
done. Thus, traditional businesses go to great lengths to maintain the continued viability of
these assets by lobbying, for example, for relief from taxes and regulations (Tassey 2007).
A manifestation of this denial of economic reality is the blaming of competitors for American
economic growth problems. China, by virtue of its size (now the world’s second largest
economy) and its position as the port of export for Southeast Asia is a frequent target. The
Chinese are justifiably criticized for currency manipulation, intellectual property theft, forced
transfers of technology and domestic content requirements to gain access to their domestic
markets, etc. However, the proposed conventional remedy of imposing tariffs on Chinese
exports will not reverse the growing contribution of structural decline to the huge trade deficit
with China. The fact is that the United States currently has bilateral trade deficits with 84
countries.
19
It has not had an aggregate trade surplus in goods since 1975. Thus, the current
economic malaise is not primarily a market-access or a business-cycle problem.
In addition to demand stimulation and increasing capital market liquidity (the latter being the
main result of so-called quantitative easing), the macroeconomic strategy for a U.S. economic
recovery is based on depreciation of the dollar to stimulate exports. Yet, although the dollar
index declined 34 percent in the past decade (2002-2011) against a basket of major currencies,
the United States is still incurring large trade deficits.
20
The fact is that no economy has ever


19
http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf.
20
The U.S. “major-currency” dollar index is the value (weighted geometric mean) of the dollar relative to a basket
of foreign currencies (Euro, English pound, Canadian dollar, Swedish krona, Swiss franc, and Japanese yen).
During this same period, the dollar decline 22 percent against an index of all currencies. See
http://www.federalreserve.gov/releases/h10/summary/default.htm.
8

prospered by depreciating its currency. The cost of this strategy is import-price inflation. Its
only legitimate use is to buy time by temporarily increasing domestic value added while the
structural problems that caused the long-term trade deficit are removed.
The bottom line is that if the underlying structure of an economy is sound, then
macrostabilization policies can return that economy to an acceptable long-term growth track
when short-term destabilizations occur. Neoclassical and Keynesian economists assume a
sound structure exists or can be imposed through competition policies, which enables the
internal dynamics of the marketplace to respond to price signals. The main difference between
the two schools of thought is the mechanism by which growth occurs. Neoclassical economists
believe that growth is determined by supply-side capital accumulation, which in turn is driven
by relative prices—totally a market response. Keynesians believe investment is a derived
demand, i.e., stimulated by consumption, which is only partly endogenous to the marketplace
(i.e., portions are created by government spending). Neither group seriously attempts to
explain the sources of the productivity of capital other than to assert it increases as part of the
private-sector investment process.
The closest traditional economics comes to recognizing the role of technology is so-called
“endogenous growth” theory.
21
Here, technology is recognized as an asset (and, therefore, its
investment process, R&D, is also recognized). But, technology is still regarded as a pure private
good with the implied assumption that relative prices effectively distribute this category of
investment capital. The resulting stocks of knowledge and physical capital are then asserted to
enable attainment of the necessary rates of productivity growth (productive efficiency is
achieved). If relative productivities change, then relative prices will reallocate resources
efficiently, thereby moving the economy toward a new equilibrium.
In summary, the most important characteristics of neoclassical economics are (1) government
intervention of any type that is internal to the dynamics of the private market is viewed as
interfering with allocative efficiency, implying that very few market failures exist, and (2)
allocative efficiency is maximized relative to a given productive efficiency through the price
mechanism (Atkinson and Audretsch, 2008). However, neoclassical economics says little about
how the existing level of productive efficiency is determined and how it changes over time. The
dynamics of long-term growth and competitiveness are therefore left to the innovation
economists who provide the elements of adaptive efficiency, which in turn drive long-term
productive efficiency.
Structural Problems Should Be the Focus of Economic Growth Policy
A technology-driven and productivity-enhancing investment strategy is essential to enable the
U.S economy or any high-income economy to compete successfully over time against other
technology-based economies. Unfortunately, the United States has, for several decades now,
failed to invest adequately in its economic future, with the result that its adaptive efficiency has
declined.


21
The evolution of the characterization of technical knowledge is assessed in Tassey (2005) along with a new
model that recognizes the public-private character of modern technologies.
9

Long-Term vs. Short-Term Growth Strategies. A critical requirement for achieving acceptable
rates of economic growth is that business-cycle fluctuations and the capacity for high long-term
growth rates be managed by very different policy instruments. Fluctuations in economic activity
always occur along a long-run growth trajectory, as shown in Fig. 1. The dashed lines represent
these short-run oscillations resulting from business-cycle imbalances. The oscillations about the
trend are managed by a combination of interest rates or monetary base control (monetary
policy) and tax rates or government spending (fiscal policy).
The solid straight lines
represent different growth
trajectories. Their relative
slopes (growth rates) are
determined by long-term
investment strategies that
result in unique portfolios of
economic assets.
A sound economic structure
actually facilitates the job of
stabilization policies by
enabling more efficient
investment and productivity
responses in recessions and a
lesser tendency toward
inflation in expansion phases.
This has been evident during the last decade in Asian economies, where many nations have
seen high sustained rates of growth and relatively subdued business cycle fluctuations, as
exemplified by the top growth trajectory in Fig. 1.
During the last ten years, the U.S growth trend has resembled the bottom growth path and
has been a manifestation of a much longer investment deficit. This substantial drop in the rate
of economic growth had a pronounced negative impact on tax revenue, which was exacerbated
by lower tax rates and higher government spending. The result was large budget deficits
appearing almost instantaneously. In the mid-2000s, a quick reversal of easy monetary policy
took place and the Great Recession followed.
Failure to Adapt. The U.S. economy boomed in the 1990s, not because of tax rates (which
were higher than in the 2000s), but because years of investment in the development and
assimilation of information technology by both government and industry finally paid off in the
form of accelerated productivity growth.
22
The message is that the modern economy cannot
grow over time simply by stimulating demand.
Yet, influential economists continue to deny this fundamental problem. The broader policy


22
While three-quarters of US industries contributed to the acceleration in economic growth in the late 1990s, the
four IT-producing industries were responsible for a quarter of that acceleration while only accounting for 3
percent of the GDP (Jorgenson, 2005).
GDP
Long-Term Growth
(smoothed pattern)
Time
Business Cycle
(actual growth pattern)
Fig. 1 Long-Term vs. Short-Term Growth Trends
Western
Economies
Asian
Economies
The Great
Recession
10

debate has largely ignored those who argue for major structural reforms in education,
investment in technology, more efficient industry structures, and government-industry
partnerships, claiming instead that all the economy needs is more demand stimulation,
specifically government spending.
23

The movement toward unbalanced growth strategies in Europe and the United States is a
response to globalization. The process of globalization began rather innocently in the 1970s and
early 1980s, with a number of industrialized countries outsourcing low paying manufacturing
and service jobs to poorer but aggressive Asian economies. However, in the mid-1980s, the
Japanese economy demonstrated the ability to acquire advanced product technologies from
western economies and combine them with its own improvements in process technologies.
With modest differences,
the Japanese growth model
of the 1970s and 1980s has
been adopted by other
Asian economies over the
past two decades. The result
has been tremendous
growth in the competitive
capacity of China, India,
Korea, and Taiwan. But this
rapid growth in Asia has
reduced rates of growth for
most other industrialized
countries. The
macrostabilization policies
implemented by western
economies have been based
largely on debt
accumulation in a furtive attempt to maintain current levels of consumption. These high debt
burdens are now perpetuating slow long-term growth rates by inhibiting domestic investment
by government.
Ignoring strucutural problems makes effective selection of long-term employment recovery


23
For example, Paul Krugman in several editorials in the New York Times stated that “all the facts suggest that high
unemployment in America is the result of inadequate demand….structural unemployment is a fake problem,
which mainly serves as an excuse for not pursuing real problems….” (September 26, 2010) and “talking about
competitiveness as a goal is fundamentally misleading” (January 23, 2011).
In an interview with the Washington Post’s Ezra Klein (“More from one of Obama’s Keynesian all-stars,” July 31,
2011), Lawrence Summers (former Director of the National Economic Council) challenged the view that
“macroeconomics was about reducing the variability of output over time, not raising its average level.” “Keynes,”
he argued, “focused on raising the average level of output through time by raising demand.” He further stated
that the current economic problem “is about demand, not some kind of structural factor in which there are
mismatches between the kinds of workers available and the kind employers are seeking.”
-2%
0%
2%
4%
6%
8%
10%
12%
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35
Fig. 2 Non-Farm Employment Growth in Recession Recoveries:
Percent Change from Recession Trough
Source: G. Tassey (2007, updated); BLS for employment data; NBER for recession trough dates
Months
from
Trough
Average of First Seven
Post-World War II
Recoveries
1990-91 Recovery
2001 Recovery
2009 Recovery
11

strategies unlikely. These barriers have become increasingly more severe as globalization has
gathered momentum. Fig. 2 shows that the average recovery in employment from the first
seven recessions after World War II occurred almost instantly. After approximately four
months, employment growth accelerated rapidly. For three decades, this pattern held. Then, in
the 1980s, significant technology-based competition began to emerge led by Japan. The
subsequent 1990-91 recession showed the initial effects of globalization. 16 months were
required to reach a positive employment level relative to the recession trough.
The situation deteriorated further in the 1990s, as the impacts of globalization deepened.
Those impacts were offset temporarily by a short-term burst in productivity growth from
several prior decades of investment in information technology (IT). However, as the benefits of
IT diffused globally, competitive positions were once again based on who produced the best
products and services relative to cost. The U.S. economy fell behind in a wide range of
industries. This decline is evidenced by the fact that employment relative to the trough of the
2001 recession did not reach a positive level for 30 months. This was nearly twice the 1990-91
recovery time and seven times the average post-war recession recovery time. With respect to
the current “recovery,” after 30 months employment has only inched above the level at the
2009 recession trough—a meager return on historic economic stimulus.
The slower recovery rates during the last two recessions are due primarily to the massive
number of manufacturing jobs lost to global competition. Table 1 indicates this process across a
range of high-tech manufacturing industries. It also shows that high-tech service industries—
often asserted by
economists to be the
automatic replacement for
the loss of manufacturing
value added—displayed
little growth in aggregate
employment during the
past decade. In fact, two
of the three high-tech
service industries for
which BLS provides data
suffered significant
employment declines.
In addition to job losses,
globalization has also
impacted the distribution
of value added between
workers and corporations. After World War II, the dominant position of the U.S. economy,
which resulted from high labor productivity, led to a rising share of value added (GDP) for
American workers.
24
However, the advent of globalization in the 1980s started a reverse shift


24
With respect to economic growth policy, value added is the bottom-line metric. In economic accounting terms, it
is largely the sum of payments to labor (wages and salaries) and payments to owners of capital (profits).
Table 1 Rate of Employment Growth by Decade (percent change)
Industry (NAICS) 1990-2000 2000-2010
Total Private
21.9 -3.3
Manufacturing Sector
-2.4 -33.2
Computers (3341) -17.8 -46.5
Communications Equipment (3342) 7.0 -50.5
Semiconductors (3344) 17.8 -45.3
Electronic Instruments (3345) -23.2 -16.7
Service Sector
28.2 3.7
Telecommunications (514) 38.5 -35.6
Data Processing (518) 49.3 -23.3
Computer Systems Design (5415) 206.2 14.9
Source: Bureau of Labor Statistics, Current Employment Statistics Survey
12

in that distribution from labor to industry, which continues today. This trend reversal occurred
because U.S. companies began reallocating labor to other economies where the same skill
levels could be obtained for lower wages and where the host governments were increasingly
able and willing to provide technical infrastructure support and other important incentives such
as a lower cost of physical capital. Overall, the failure to increase U.S. domestic labor’s skills and
the decline of unionization have resulted in an increasingly larger share of value added going to
corporations in the domestic economy.
25

Underinvestment in Workforce skills. In today’s information driven and highly complex
economies, labor is much more heterogeneous than was the case in the Industrial Revolution
and hence substitution is more limited, not only across industries but within industries, as well.
This heterogeneity has increased the potential for skill gaps in the labor force, which explains
how aggregate U.S. unemployment in 2011 could be 14 million while 3 million jobs went
unfilled.
26
One survey of skilled worker availability found that 32% of manufacturing companies
were experiencing moderate to serious shortages in the availability of qualified workers, with
certain sectors, such as aerospace/defense and life sciences/medical devices, reporting much
higher levels of worker shortages.
27

Globalization is increasingly solving this problem for corporations by greatly expanding the
supply of skilled labor. In this context, it is ironic that such a furor was raised over the Boeing
Company’s decision to build a new plant in low-unionized South Carolina instead of highly-
unionized Washington, given that the foreign content of Boeing’s new 787 Dreamliner is 90
percent.
28

Yet, while these indicators imply the need for a crisis approach to education reform and much
more investment in worker retraining, the response so far has been highly inadequate.
According to the College Board, the United States once led the world in the percentage of 25-
to 34-year-olds with college degrees, but it now ranks 12
th
among 36 developed nations. And,
according to the testing organization, ACT, fewer than 25% of 2010 high-school graduates who
took the ACT college-entrance exam demonstrated the skills necessary to pass entry-level
college courses.
More broadly, the entire school system is inadequate for today’s modern technology-based
economy. More incentives for students to choose science and engineering are needed and a
much broader education and training infrastructure has to be developed to expand the skilled
workforce. K-12 might have to become K-14 to truly upgrade U.S. workers’ skills, with the


25
Work stoppages of more than 1,000 workers averaged approximately 300 per year for the first three decades
after World War II. After 1980, however, the rate declined precipitously to an annual average of 16 since 2002.
Source: Bureau of Labor Statistics (http://www.bls.gov/news.release/wkstp.t01.htm). The decline in impact of
unions is partly due to the increasing heterogeneity of worker skills, but a major force has been the pressures of
globalization.
26
BLS data as of May 2011. See http://www.bls.gov/news.release/jolts.nr0.htm.
27
People and Profitability, A Time for Change: A 2009 People Management Practices Survey of the Manufacturing
Industry. Deloitte, the Manufacturing Institute, and Oracle.
28
David Pritchard, Canada-United States Trade Center at the State University of New York at Buffalo.
13

additional two years being community-college level training in specific technical (vocational) job
categories, including apprenticeships with high-tech small firms who often cannot afford the
overhead associated with bringing young workers up to adequate levels of productivity.
29

The track to “high-tech” vocational training must begin in high school to avoid the all-or-
nothing decision now faced by American K-12 students: go to college whether or not it suits the
student or the needs of industry or be relegated to low-paid trades, most of which are in
declining industries or service industries with little upward mobility potential. Finally, the school
year must be lengthened. At 180 days, graduating U.S. high-school students will have spent
more than a full school year less in the classroom than the average for other countries; so, even
if the quality of K-12 were competitive, American students would still be at a skills
disadvantage.
Underinvestment in Productivity-Enhancing Physical Capital. Long-term underinvestment has
been exacerbated for much of the past decade by a national savings rate that hovered around
zero. This has meant that (1) virtually all investment was financed by foreign capital and (2) all
growth was based on consumption. Neither provides a strong foundation for increased
productivity growth rates.
If policymakers wanted to stimulate greater productivity in the domestic economy, one
would expect a bias toward policies that leverage investments in the stocks of companies that
either develop or use productivity-enhancing assets. However, Fig. 3 shows a three-decade
decline in the rate of
growth of fixed private
investment in hardware
and software (which are
the primary types of
investment by which
technology has its
productivity impacts).
General tax cuts were
tried in the 2000s as a
means of maintaining the
growth rates of the
1990s. However, even
when general tax
incentives are targeted at
investment, the effect is
to induce investment in
the existing capital
structure and thereby largely in the existing stock of technical knowledge. Moreover, general
tax expenditures for industry are small compared to other categories of tax breaks. A study by


29
The German Fraunhoffer Society model includes successful approaches to training and transitioning new skilled
workers to small firms.
108.8%
84.9%
107.8%
167.7%
14.6%
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
1960-70 1970-80 1980-90 1990-00 2000-10
Fig. 3 Fixed Private Investment: Hardware and Software
Growth by Decade (in 2005 dollars)
Source: Data from Bureau of Economic Analysis, NIPA Table 5.3.5 (includes both equipment and software) and
Table 5.3.4 (price indexes for fixed private investment)
14

the National Tax Foundation estimates that generally available tax provisions will cost $54.8
billion in 2011. This amount is relatively modest compared to the projected exclusions for
employer-provided health insurance ($177 billion), pensions and 401Ks ($142 billion), the
mortgage interest deduction ($104 billion), and tax benefits for state and local governments
such as the exclusion for bond income ($92 billion).
30
In contrast, the current annual cost of the
R&D tax credit, which can help enhance the productivity of physical capital, is approximately
$8.5 billion.
In fact, Congress has consistently done virtually everything conceivable to direct household
savings into real estate—the most unproductive of all asset classes with respect to economic
growth. In 1996, Congress changed the tax treatment of real-estate capital gains to favor
investment in housing. Most households will never pay capital gains taxes on a real-estate sale.
Moreover, housing is the only investment for which the interest on borrowed funds is tax
deductible. An added incentive is the deductibility of property taxes from personal income
subject to tax.
31
The flow of funds into housing has been additionally leveraged by the
government-sponsored enterprises (GSEs), principally Fannie Mae and Freddie Mac. They
create additional funds for home-mortgage lending institutions by buying home loans (thereby
freeing funds for banks to re-lend) and by guaranteeing principal and interest payments.
Together these two GSEs control 90 percent of the secondary mortgage market. So, if an asset
class is tax preferenced on the purchase, tax preferenced on its holding period, and tax
preferenced on its sale, funds will flow out of other asset categories into the favored asset
class.
Not surprisingly, then, Americans have favored housing, making it their single largest asset. In
turn, they have underemphasized investments in financial instruments that are used by
corporations to raise investment capital. For example, the top 1 percent of Americans owns half
of the country’s investments (stocks, bonds, mutual funds), while the bottom 50 percent own
only 0.5 percent.
32
As a result, the stated national objective of having all Americans own their
own homes has resulted in policies that have collectively redirected household resources away
from productivity-enhancing investments, in spite of a lower tax rate on long-term capital gains.
In summary, conventional stabilization and so-called growth policies ignore the fundamental
causal relationship between the economy’s structure and its ability to support sustained
economic growth. It is true that investment is a component of fiscal policy. However, the
current and, in fact, the typical investment content of fiscal stabilization efforts is too little, too
narrow in focus, and too short-term. Unless addressed, the severe structural problems
documented in this paper will constrain any recovery resulting from fiscal or monetary


30
National Tax Foundation, “Putting Corporate Tax ‘Loopholes’ In Perspective.” The report is available from the
Foundation at www.taxfoundation.org/publications/show/26580.html.
31
The Fiscal Times, a news organization funded by the Peter G. Peterson Foundation, estimates that these three
major tax breaks accounted for $135.7 billion in reduced tax revenue in 2010.
32
Source: Institute for Policy Studies.
15

stimulation alone.
33

In contrast, investment in productivity growth offers the prospect of positive long-term
returns from investment. The reason is that superior productivity results in larger shares of
global markets, which, in turn, increases the demand for domestic labor. The economic growth
potential is huge because, as previously noted, 95% of all future consumers live outside the
United States. Moreover, the American consumer will likely not significantly increase
consumption for the foreseeable future, as households work down debt, thus reducing
domestic consumption as a source of growth for some time. The implication is that, the U.S.
investment strategy must be designed to compete for global customers and must therefore be
export oriented. Moreover, long-term productivity growth requires increasing the technological
content of products, processes, and services. Technology investments demand higher skill
levels, so that rates of compensation for the labor force will rise over time, as well.
The Core Structural Problem is the Failure to Emphasis the Core Driver of
Long-Term Productivity Growth: Technology
The argument of excessive reliance on macroeconomic stabilization policies, especially when an
economy has underlying structural problems, requires specification of a complementary set of
microeconomic growth strategies to balance the policy mix. The imperative to either
restructure or replace traditional industries over time requires (1) a consensus on the sources
of growth for several decades into the future and (2) provision of the resources necessary to
restructure the economy’s stock of economic assets accordingly. Specifically, the structural
changes occurring rapidly in the global economy demand that an investment-driven recovery
be focused on a wide array of productivity-enhancing technologies.
The central role of technology in long-term productivity and output growth has been
documented by economists over several decades. Yet, the still dominant neoclassical economic
perspective, which emphasizes reliance on price-induced resource reallocation and which still
dominates high-level policy advisory positions, gives little or no attention to complex public-
private processes by which technologies are developed, assimilated and ultimately used to
increase productivity. Not surprisingly, therefore, neoclassical economists, by ignoring the
public-private nature of new technology development, its appropriability problems and long
gestation times, can casually dismiss concerns over underinvestment—especially by the public
sector.
Worker Incomes are Driven by Multifactor Productivity. Furthering denial of the limits of
current macroeconomic growth strategies is the perception that U.S. productivity is growing at


33
Recent research has indicated that the fiscal multiplier is declining due to the effects of globalization. Important
factors cited are increased trade (stimulated demand is used on imports), flexible exchange rates (deficit
spending can lead to currency depreciation and hence inflation), and degree of indebtedness (government debt
in excess of 60 percent of GDP reduces the fiscal multiplier to approximately zero). Also, the form of fiscal
stimulus does not seem to matter, except in developing countries where the government investment multiplier
is significantly higher than the multiplier on government consumption. See Ilzetzki, Mendoza, and Vegh (2010)
and commentary by Nesvisky (http://www.nber.org/digest/mar11/w16479.html).
16

an acceptable rate with the implication that the fundamentals for future economic growth are
sound.
The most widely disseminated and discussed productivity data are for labor. However, labor
productivity is only a partial measure of the total productivity of an economic system. The more
accurate metric is “multifactor productivity (MFP),” which includes the impact of capital and
other inputs.
34
Nevertheless, because labor productivity is easier to calculate, it is available
much faster than MFP and has the added advantage of being simpler and hence more easily
understood. Thus, the media and the policy infrastructure both focus on labor productivity
data.
In calculating domestic labor productivity, BLS only counts labor hours worked in the
domestic economy. To the extent that labor input for a particular industry is offshored, the
“measured” labor productivity is overstated. Thus, increased offshoring in the past 15 years
seems to be a factor in the
apparently faster rate of
growth of labor productivity
curve, as indicated in Fig. 4.
However, corporate
managers recognize the
relationship between labor
and capital and thus pay
domestic workers their
“true” productivity, which is
based on their interactions
with physical and
intellectual capital—the
driver of MFP. This
relationship is indicated in
Fig. 4 by the fact that real
wages track MFP, not labor
productivity. These slower rates of growth in MFP and real labor incomes are a more accurate
indicator of the rate of adaption to the growing pressures of global competition.
MFP has its own measurement problem: the use of inaccurate price indices applied to the
cheaper imported inputs. Specifically, inaccurately high price indices result in lower imputed
input quantities, which when distributed over the same labor in the importing domestic
industry, causes in an increase in “measured” MFP (Mandel and Houseman, 2011; Houseman et
al, 2011). To the extent inputs are cheaper, domestic corporate profits are enhanced.


34
The Bureau of Labor Statistics defines multifactor productivity as “an index relating the change in real output to
the change in the combined inputs of labor, capital, and intermediate purchases consumed in producing that
output. Multifactor productivity growth measures the extent to which output growth has exceeded the growth
in inputs, and reflects the joint influences on economic growth of a variety of factors, including technological
change, returns to scale, enhancements in managerial and staff skills, changes in the organization of production,
and other efficiency improvements.”
40
60
80
100
120
140
160
180
1965
1970
1975
1980
1985
1990
1995
2000
2005
Fig. 4 Policy Focus on Multifactor Productivity
Trends in Productivity and Income Private Non-Farm Sector, 1965-2009
Source: Bureau of Labor Statistics
Labor Productivity
Real Hourly Compensation
Multifactor Productivity
Index
17

However, this does not result in additional domestic labor income, as corporate managers
know where the increases in productivity are coming from. It does result in lower employment
for the domestic supply chain as a whole.
35
For the long run, the major problems for future
productivity growth are a stagnant national R&D intensity and a decade-long drop in the
growth rate for fixed private investment.
The Technology Investment Option
The ultimate objectives of economic growth policy are to create jobs and to increase per capita
income. With respect to employment, recent analysis shows that with one exception, “over
rolling ten-year periods, employment and productivity growth have an almost perfect
correlation”.
36
Moreover, decades of research have demonstrated beyond a doubt that
technology drives long-term productivity growth and hence incomes. BLS data show that in all
but one of 71 technology-oriented occupations, the median income exceeds the median for all
occupations. Moreover, in 57 of these occupations, the median income is 50 percent or more
above the overall industry median (Hecker, 2005). The bottom line is that the high-income
economy must be the high-tech economy.
The industries with high-skilled labor are also the industries investing in new technologies to
combine with this labor. Thus, economic growth policy must place more emphasis on increasing
multifactor productivity, which is the driver of value added (profits plus wages and salaries).
Achieving this goal requires coordinated advances in science, technology, innovation, and
diffusion (STID) assets.
This strategy requires investments in multiple drivers: technology, education, capital
formation, and industry infrastructure. As shown clearly in Fig. 3, private-sector investment in
hardware and software within the U.S. economy has stagnated, which does not bode well for
future productivity growth. Equally important, investment in the driver of long-term growth in
the productivity of capital—technology—has stagnated, as well.
37
So, a policy imperative is to
increase national R&D spending in order to increase the amount of technology available to be
embodied in new productivity-enhancing capital stock.
However, a major policy problem is the fact that R&D is not a homogeneous investment, as
assumed by neoclassical economic growth models and even by innovation economists.
Therefore, in addition to the amount of R&D, the composition of R&D is a critical strategy
metric, and the efficiency by which each of these variables is managed is increasingly important
in a global economy with shrinking R&D cycle times.
The Amount of R&D Investment. This has historically been the dominant STID policy metric.


35
These same measurement problems may be resulting in an overestimate of GDP (Houseman et al, (2011).
36
Source: Bureau of Economic Analysis and McKinsey Global Institute. Data compiled by McKinsey (see Manyika et
al, 2011)).
37
A few noted economists, such as Douglas North and Paul Romer, have emphasized the critical role of technology
in economic growth, but their views have been largely swamped by the dominant neoclassical and Keynesian
economic philosophies (Atkinson and Audretsch, 2008, p. 2).
18

However, in spite of relatively long-term debate over the importance of investment in R&D, the
U.S. economy has steadily lost ground with respect to the rest of the world. A major reason is
that although the science, technology, innovation, and diffusion (STID) community has argued
with increasing force that the United States is under-investing in innovation and subsequent
market development (scale-up), the relatively small size of the “high-tech” portion of the
economy (approximately 7 percent of GDP) has left it in a relatively weak position politically
wither respect to getting priority status for needed major policy initiatives.
38

The importance of the amount of investment in R&D can for the first time be demonstrated
using product and process innovation data recently compiled by NSF for a broad cross-section
of industries. Fig. 5 compares an index of industry innovation rates with industry R&D
intensities for 17
industries.
39
The index is
created by adding the
number of product and
process innovations for
each industry in the NSF
database and plotting this
index against the R&D
intensity for each industry.
A positive correlation is
clearly evident,
underscoring the
importance of R&D
intensity as a major policy
variable.
The vertical dashed line
in Fig. 5 indicates the
minimum ratio of R&D to
sales that typically qualifies an industry as R&D intensive. 10 of the 17 industries fall below this
minimum.
40
Over time, these industries will become increasingly less competitive and provide


38
The other 93 percent of the economy does low-to-modest amounts of R&D but depends largely on the much
smaller high-tech sector for most technology it uses. This dominant set of traditional industries is where the
majority of jobs are being lost and profit margins squeezed. Its managers and workers are understandably
worried but resist shedding increasingly noncompetitive assets and get retrained without aggressive government
support. This “installed-base” effect is a major barrier to restoring an economy’s competitiveness economy.
39
R&D intensity is the amount of R&D spending by a firm or industry divided by net sales. For the economy as a
whole, it is national R&D spending divided by GDP. It indicates the amount of an economy’s output of goods and
services that are being invested in developing technologies as a means of competing in the future. Larger
economies have to spend more on R&D than do smaller economies to maintain an aggregate competitive
position in global markets, so it is the ratio of R&D to GDP that should be the policy driver, not the level of R&D
spending.
40
The three un-shaded markers indicate service industries and the industry in the extreme upper right corner is
software.
0
20
40
60
80
100
120
140
0 5 10 15 20 25
Fig 5 Rate of Innovation vs. R&D Intensity:
% of Companies in an Industry Reporting Product/Process Innovations, 2003-2007
Index
R&D
Intensity
Index = sum of percent of companies in an industry reporting product innovations and percent reporting
process innovations. Sources: Science and Engineering Indicators 2010 , Appendix Table 4-14; Boroush (2010).
19

fewer jobs and lower rates of pay.
This positive relationship between R&D intensity and innovation is becoming increasingly
important given that $1.4 trillion is spent annually on R&D in the global economy—a huge level
of investment, especially given the substantial leverage of resulting innovations on subsequent
capital formation for production and subsequent marketing operations. In fact, economic
studies have estimated the return on R&D to be four times the return on investment in physical
capital, implying that R&D investment should be increased by a factor of four (Jones and
Williams, 1998, 2000).
This leverage on subsequent investment underscores the point that innovation is only the
initial commercial application of a new technology. Over time, the majority of the economic
benefits from investment in technologies are realized from scale-up and subsequent attainment
of significant global market shares. In this regard, Table 2 provides a vivid demonstration of the
importance of R&D intensity for manufacturing industries. The industries are segregated into
high- and low-R&D-intensity groups for which the average rates of real-output growth are
calculated for the periods 2000−07 and 2000-09. The difference in average growth rates
between the two groups is remarkable.
41
Further, Table 2 provides a perspective on the relative
effects of the 2008-09 recession on the two groups. While the downturn negatively affected


41
This is the case even though one of the R&D-intensive industries, Communications Equipment, experienced a
sharp drop in real output during these time periods due to significant offshoring.
Table 2 Relationship Between R&D Intensity and Real Output Growth
Industry (NAICS Code)
Ave. R&D Intensity,
1999-2007
Percent Change in
Real Output, 2000-07
Percent Change in
Real Output, 2000
-
09
R&D Intensive:
Pharmaceuticals (3254) 10.5 17.9 4.9
Semiconductors (3344) 10.1 17.0 1.1
Medical Equipment (3391) 7.5 34.6 39.5
Computers (3341) 6.1 109.9 147.0
Communications Equip (3342) 13.0 -40.0 -59.7
Group Ave: 9.5 Group Ave: 27.9 Group Ave: 26.6
Non
-R&D Intensive:
Basic Chemicals (3251) 2.2 25.6 -7.8
Machinery (333) 3.8 2.3 -22.4
Electrical Equipment (335) 2.5 -13.4 -33.4
Plastics & Rubber (326) 2.3 -5.2 -28.0
Fabricated Metals (332) 1.4 2.6 -23.6
Group Ave: 2.5 Group Ave: 2.4 Group Ave: -23.1
Sources: NSF for R&D intensity and BLS for real output.
20

several of the R&D-intensive industries, as a group their average grow rate remained effectively
unchanged. In contrast, all of the non-R&D intensive industries suffered significant declines in
output growth when the recession is included. The major policy implication is that when
decision makers are looking for levers to stimulate output, job growth and worker incomes,
high R&D intensity should be a primary target. But, such a policy target cannot be achieved
through conventional macrostabilization policies.
Manufacturing industries are important to long-term economic growth in an advanced
economy, not only because worker incomes are higher than the average for all industries but
also because the manufacturing sector does a disproportionately large share of domestic
industry R&D (67 percent) and employs a disproportionately large share of R&D personnel (57
percent). Allowing this sector to offshore would decimate the economy’s R&D capacity and
hence its overall innovation infrastructure. The problem is that the average R&D intensity for all
U.S. manufacturing is only 3.7 percent—well below the lower end of what are considered R&D-
intensive industries and, surprisingly, unchanged from the 1980s. However, as the dramatic
negative change in the growth rate of the Communications Equipment industry (NAICS 3342)
demonstrates, even a high R&D intensity is no longer a sufficient condition for maintaining
domestic production content. The high R&D intensity of this industry indicates that the
remaining domestic economic activity is competitive. However, it is also clear that other
segments have been offshored, thereby reducing the domestic industry’s share of the global
industry’s value added and consequently domestic jobs.
A total technology-life-cycle growth strategy is mandatory. Decades of economic research
have shown clearly that technology is the long-term driver of productivity growth.
42
One would
therefore think that
technology investment
would be the highest
priority among the
elements of an economic
growth strategy. Yet, its
role is hardly mentioned
in current economic
growth policy debates
and, therefore, the
migration to a new
technology-based growth
strategy has been
stymied.
This investment myopia
is shown clearly in Fig. 6,
which depicts long-term
trends in U.S. R&D


42
See Tassey (2010, Chap. 3) for a summary of this literature.
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005
Fig. 6 U.S. R&D Intensity: Funding as a Share of GDP, 1953-2008
Total R&D/GDP
Federal R&D/GDP
Industry R&D/GDP
Source: National Science Foundation
21

intensity. The peak R&D intensity was reached in the mid-1960s and has not been exceeded in
the subsequent 45 years, in spite of the relentless growth in R&D investment by other
countries. The United States was once the most R&D intensive economy in the world, but its
ranking has steadily declined. U.S. peak R&D intensity was reached in the mid-1960s and has
not been exceeded in the subsequent 45 years, in spite of the relentless growth in R&D
investment by other countries. As of 2008, OECD data show that the United States ranked
seventh in R&D intensity.
The rapid expansion of national R&D spending in the early post-World-War-II period was
driven to a significant extent by national security concerns, but the latter part of this uptrend
was the result of a realization that the role of science and technology would expand rapidly in
all segments of society. President Kennedy’s 1961 speech calling on the country to greatly
expand S&T investment was responded to for only a few short years (until the mid-1960s) and
then largely forgotten. This trend indicates that the U.S. economy is no more committed to
investment in technology
today than 50 years ago.
Fig. 7 reinforces how
badly the United States is
lagging its competitors in
responding to growing
technology-based
competition. This last place
growth rate is not
something an advanced
economy can afford with
the world’s R&D spending
continuing to expand
rapidly. China’s dramatic
growth in R&D is coming
off a low base of R&D
intensity, but only apostles
of denial will try to
downplay its long-term
significance, especially as it is a manifestation of a much longer national plan to attain
technological superiority across multiple industries. The United States still conducts more R&D
than any other economy (as it should being the largest economy), but its slipping R&D intensity
foretells a constrained rate of economic growth that will continue until an aggressive national
strategy is implemented to reverse these trends.
The Composition of R&D Investment. An accurate model of technology-based growth
recognizes the several phases by which scientific knowledge is turned into successively more
applied technical knowledge until the point of commercialization is reached. The earliest phase
of technology research seeks to prove the concept of how the technology will eventually
provide commercially viable products or processes. This “proof-of-concept” technology
research typically occurs a long-time before commercialization. Its broad “technology-platform”
170.2%
135.1%
65.0%
61.0%
42.2%
26.2%
20.5%
10.4%
0%
20%
40%
60%
80%
100%
120%
140%
160%
180%
China
Singapore
Finland
Taiwan
South
Korea
Japan
Germany
United
States
Sources: OECD, Main Science and Technology Indicators, 2010/1
Fig. 7 Changes in National R&D Intensity, 1995-2008
22

character provides the potential for multiple market applications; that is, the aggregate
potential economic growth impact is substantial. However, the higher discount rate applied by
the private sector to adjust expected rates of return for time and also for both technical and
market risk leads to
significant underinvestment
by industry in this early-
phase technology research.
Finally, the broad sets of
potential applications
(economies of scope)
characteristic of modern
generic technology
platforms typically extend
beyond the market foci of
individual firms, thus
further reducing the
expected rate of return
(Tassey, 2007).
The consequent trend
toward less investment by
industry in radically new
technologies with long-term and large economic impact potential is demonstrated in Fig. 8.
Using 19 years of data on annual planned company R&D expenditures from surveys of its
members by the Industrial Research Institute, the bar chart shows trends in two “sea-change”
indexes of R&D investment.
43
The light-shaded bars are the annual index numbers for “new
business projects”; that is, short-term R&D aimed market applications within current
technology life cycles. The dark bars are the annual index numbers for “directed basic
research”; that is, investment in longer-term, higher-risk R&D projects that will define future
technology platforms and hence life cycles.
The trends in the two indexes are starkly different. Over almost two decades, U.S. industry
has regularly increased its investment in short-term R&D to respond to growing competitive
challenges in the global economy, while regularly decreasing planned investments in the more
radical research that provides the technology platforms for competing in future technology life
cycles.
The Federal Government has not responded. As indicated in Fig. 6, the 50-year decline in
government’s R&D spending relative to GDP shows no sign of abating. In fact, government R&D
budgets are under threat of absolute declines from current levels. Even the long-term growth in
industry’s R&D intensity topped out in the last decade, as increasing portions of domestic
company R&D funding are allocated to other economies. Yet, seldom in the interminable


43
A sea-change index is defined by the IRI as the difference between the number of companies indicating a
planned increase of more than 2.5 percent (allowance for inflation) in a particular category of R&D in the
forthcoming year and the number of companies indicating a planned decrease in spending in that year.
-40
-30
-20
-10
0
10
20
30
40
50
60
70
1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
“Directed
Basic
Research”
“New
Business
Projects”
Fig. 8 The “Valley of Death” is Getting Wider
Trends in Short-Term vs. Long-Term US Industry R&D, 1993-2010
Compiled from the Industrial Research Institute’s annual surveys of member companies. Note: sample
size is not constant from year to year.
Index
23

discussions in western economies of what to do about inadequate rates of economic growth
are these and other indicators of technology-based investment discussed.
In addition to its inadequate size, the Federal Government R&D budget has historically been
focused on specific mandated missions (national defense, health, space exploration, etc.) rather
than on economic growth as a first-order objective.
44
In the past, many of the technologies
resulting from mission-oriented research have eventually spun off into significant additional
commercial applications (that is, economies of scope were eventually realized from
government-funded the platform technologies). This funding strategy worked well for several
decades after World War II when the U.S. economy dominated the world.
However, the indirect path by which mission-oriented technologies are developed and then
later spun off to varying degrees into commercial applications draws out the R&D and hence
the technology life cycles. The lengthy indirect process of realizing economies of scope from
new technologies is no longer competitive in a world economy that conducts over a trillion
dollars of R&D per year and is using increasingly efficient mechanisms for managing this
investment. The result is that intense technology-based global competition is compressing all
technology life cycles with the result that windows of opportunity are increasingly narrow. The
severity of the composition problem for the U.S. economy is underscored by the fact that
mission R&D spending comprises approximately 90 percent of the total Federal R&D budget.
Government, with a lower discount rate, the ability to undertake riskier projects, and the
resources to support a broad portfolio of long-term research projects must be a major
supporter of the elements of complex modern technologies with public-good content. Yet, as
Fig. 6 demonstrates, government’s capacity to contribute in the early part of the R&D cycle to
next generation technologies has steadily shrunk relative to the size of the economy and even
more so relative to the size and importance of technology assets in today’s global economy.
A considerable portion of government-funded R&D is performed by industry. Thus, if
government R&D budgets had grown in concert with the economy’ growth, the decline in
industry’s own funding of breakthrough research (Fig. 8) could have been compensated for.
Such research is critical to long-term rates of innovation because it focuses on the transition
phase between basic research (which has no intrinsic commercial value) and development
(which results directly in market applications, i.e., innovations). This transition phase (proof-of-
concept research) plays the critical role of reducing technical and market risk sufficiently to
encourage industry to invest the far larger funds required for applied R&D and then finally the


44
For example, an examination of DARPA’s research project portfolio shows a number of targeted technologies
that clearly have commercial and hence economic-growth potential beyond defense applications, but other
projects are just as clearly limited in potential for yielding economies of scope; i.e., market applications beyond
defense. This is not a criticism of DARPA. It selects and manages a portfolio of technologies optimized for
national security objectives, as it should. However, this portfolio is not optimized for economic growth in
general, so relying largely on its substantial budget is no longer adequate as a national strategy for developing
new technology platforms. Other agencies (e.g., DoE/ARPA-E) have programs targeting the same early phase of
the R&D cycle, but their budgets are much smaller and their research portfolios have similar issues. The
government–wide result is overlap in some technology elements and gaps in others.

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